Second-Half Focus Turns to U.S. Political Drama

By

Tom Lauricella

Updated July 1, 2012 3:14 p.m. ET

Financial markets seem to have gotten another reprieve from worries about Europe. But attention is now turning to the U.S., where concerns over political stalemate threaten to dominate the second half of 2012.

With government policy playing a greater-than-usual role in driving financial markets, investors are nervously eyeing the November U.S. presidential election and the year-end expiration of tax cuts and economic stimulus that could drive the U.S. economy into recession should Congress fail to step in.

ENLARGE

Some investors question whether there will be much more clarity after the election. They point to the likely budget showdown over the so-called fiscal cliff.
Ray Bartkus

Some investors worry the uncertainty alone could stall business activity. And that might imperil one of the few continued bright spots in the markets: healthy corporate profits.

The chain reaction could keep investors of all stripes on the defensive, even for U.S. stocks and emerging markets, where many investors have had a positive bias.

"I feel like you don't want to take too much risk," says
Joseph Milano,
manager of the
T. Rowe Price New America Growth Fund
,
which has $3.3 billion in assets and focuses on stocks of fast-growing companies. "The next three or four months are going to be a little bit of a vacuum."

Political question marks in the U.S. are just the latest reason why many investors are leery. In the second quarter, another flare-up of worry about Europe and slowing global economic growth helped send the Dow Jones Industrial Average to a 2.5% decline.

More in Quarterly Markets Review & Outlook

Despite the unsettled and volatile environment, the Dow posted a respectable 5.4% gain at this year's halfway point and the Standard & Poor's 500-stock index rose 8.3%, even after a 3.3% retreat in the second quarter.

Mr. Milano and others worry that the uncertainty in Washington will weigh on the economy and corporate profits, putting those gains at risk.

In the second quarter, Mr. Milano spent several weeks on the road meeting with executives at dozens of companies. When it comes to spending or hiring, "there's not a reason to make big decisions in front of what is a pretty important election," he says.

"There are plenty more roadblocks on the way," says
David Mann,
head of regional research for the Americas at Standard Chartered Bank.

Meanwhile, investors have been rattled by a slowing of China's economy, a major contributor to global economic activity and profits. A big problem for China is that the world's largest developed economies, which are its prime export markets, are struggling to grow under the weight of a mountain of debt and lagging effects of the financial crisis.

And in the U.S., ominously, many investors increasingly believe the Federal Reserve is reaching the limits of its abilities to prop up the economy, where employment gains have slowed after healthier readings earlier in the year.

The second quarter also hammered economically sensitive commodity prices. Oil collapsed 18%, and copper slid almost 9%. Investors flocked to the perceived safety of government bonds, sending the yield on the U.S. Treasury 10-year note down 0.6 percentage point to 1.66%.

Quarterly Quota

Volatility also returned after a calm start to the year. The Dow posted 22 days of triple-digit moves during the second quarter, compared with six in the first quarter.

Stocks have gotten support from continued healthy corporate earnings. During the first quarter, the companies in the S&P 500 beat much-reduced profit expectations, including some record profits. Margins also hit a record. Although companies have been talking down expectations for earnings, analysts believe profits hit yet another record in the second quarter.

It also helps that stocks seem relatively cheap based on several metrics, some investors note. The S&P 500 finished the second quarter at a below-average price-to-earnings ratio of roughly 13, based on expected earnings for the next 12 months, according to S&P Capital IQ.

ENLARGE

"Valuations are reasonable," for U.S. stocks, says
Mark Keller,
chief investment officer at Confluence Investment Management of St. Louis, which oversees about $1.1 billion. "We think the U.S. is in a superior situation among the industrialized countries."

Mr. Keller says the fall elections are a hurdle, but he is hopeful that investors will be able to better handicap the outcome and impact as Nov. 6 draws closer. Other investors question whether there will be much more clarity after the election.

That is especially the case for the likely looming budget showdown over what has become known as the fiscal cliff. If Congress takes no action, the U.S. economy will likely be driven into recession, economists say.

"It's unclear whether some of these issues will be resolved in November," says
Leila Heckman,
senior portfolio manager at Roosevelt Investment Group, which manages more than $5 billion.

At Windhaven Investment Management in Boston, which oversees $11 billion, Chief Investment Officer
Stephen Cucchiaro
thinks U.S. politicians won't come to a full resolution of the fiscal cliff, but there will be a deal that delays some of the impact. Should the financial markets react poorly to that outcome, he believes the Fed will step in with another round of easing.

As a result, while Windhaven's portfolios of exchange-traded funds are tilted toward fast-growing technology stocks in the Nasdaq-100, the portfolios also are heavy on real-estate investment trusts and strategies focused on companies with growing dividends. Given the possibility for political gridlock and additional easing, Windhaven also is heavy on gold, Mr. Cucchiaro says.

Markets won't have to wait for evidence of the chilling impact of election uncertainty, Mr. Cucchiaro says. "It is already happening."

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